Hedge fund laws, starting a hedge fund, news and events…

Tag Archives: hedge fund lawyer

As of the date we published this list of important hedge fund articles, the Hedge Fund Law Blog has over 600 posts. In order to highlight some of the more important items on this website we have created the following list of articles which we think will be useful for most of our readers. Articles without links will be forthcoming and we look forward to hearing your feedback on what information you would like to see in the future. The categories include:

Basics & Structure

Offering Documents

Service Providers

Investment Adviser Regulation

Futures & Commodities Regulation

Marketing & Advertising

Operational Issues

We would also like to remind managers who are thinking of starting a fund to view our Start Up Presentation.

On Thursday evening at the Roxie Theatre in San Francisco, the professional women’s organization 100 Women in Hedge Funds sponsored the showing of Floored, a documentary by ex-floor trader James Allen Smith that offers a peek inside the lives, successes, and struggles of former traders of the Chicago trading floor (a.k.a. the “pit”).

Those who showed up to watch the film made for the perfect audience–traders, hedge fund managers, and other financial industry professionals schmoozed over wine and cheese before the showing, during which boos, laughter, applause, and verbal comments erupted each time the audience could relate to traders’ stories or make fun of their often idiosyncratic comments. Upon leaving trading, one notable former trader (and quite the character) Mike Walsh took up the hobby of hunting lions, giraffes, and other wild animals.

Through interviews and live footage of pit trading, the documentary tells the story of the Chicago Board of Trade’s (now the Chicago Mercantile Exchange, CME) humble beginnings–it opened in 1898 as the Chicago Butter and Egg Board because it only traded butter and egg contracts!–to the roller coaster ride experienced by floor traders during the peak of futures and options floor trading in the mid-1990s.

Starting in 1992 and still in use today in the pit is the combination of open outcry, the system of loudly shouting over competitors often associated with floor trading, and GLOBEX, an electronic trading system which works alongside open outcry to make trading more efficient. The idea behind trading revolves around buying a commodity at one price and then trying to sell it for a better price in order to make a profit. In the film, the traders described this system as a game–one trader stated that when the bell goes off (to initiate the opening of trading hours), he experiences an adrenaline rush as if he were playing a sports game. Another trader commented, “Trading is not a normal job. When you are in there [the pit] from 8:30 to 3:15, it’s all about money!”

The main issue traders discussed was the shift from floor trading to electronic trading. The majority opinion was that computers changed the dynamic of trading in an unfavorable way and that trading in person helps make the price of commodities more efficient. One trader commented that open outcry was more “honorable”. There is also a generational issue, as older traders who did not grow up using computers had trouble figuring out complicated electronic trading platforms. Essentially, those traders who still had enough money to continue trading and who were able to use the electronic systems continued trading, while those who lost too much money in the pit were forced to leave trading altogether.

According to the CME, the options and futures trading floor remains grounded in floor trading, which accounts for 90% of trades with the remaining 10% occurring electronically. The futures pit, however, has seen the biggest crossover to electronic trading, with approximately 85% of trades taking place on the computer and the remaining ones in the pit.

After the film, Smith, who watched the film alongside his audience, stood at the front of the theatre for a Q&A session. He was asked about his background–he went to art school then found himself doing web design for finance businesses in Chicago, where a friend suggested he make a movie about floor traders. He even dabbled in trading and reached out to his network when casting traders for the film. When asked why former traders were willing to open up about their personal lives on film, he commented that less successful traders are often more likely to talk, while more successful traders remain tighter-lipped. Finally, when asked what impression of traders he wanted to leave with audiences, Smith replied that traders are usually stereotyped as “greedy a**holes”, and he wanted to show that traders are more “dynamic than just that part of their personalities” by offering a “more rounded impression [of traders]” through his film.

Today the House Financial Services Committee voted to require hedge fund managers to register with the Securities and Exchange Commission. While private equity firms are also required to register under the proposed bill, managers to venture capital funds are excluded from this registration requirement.

The bill will next be presented to the House of Representatives and if it passes there it will move onto the Senate and eventually to President Obama to sign into law. The name of the bill is the Private Fund Investment Advisers Registration Act of 2009. For the full text please see H.R. 3818.

Washington, DC – Today, the House Financial Services Committee passed H.R. 3818, the Private Fund Investment Advisers Registration Act, introduced by Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. The Committee passed H.R. 3818 with extensive bipartisan support by a vote of 67-1. Tomorrow, the Committee is expected to vote on Chairman Kanjorski’s H.R. 3817, the Investor Protection Act and H.R. 3890, the Accountability and Transparency in Rating Agencies Act.

“The Private Fund Investment Advisers Registration Act, which passed today with wide-ranging bipartisanship support, will force many more financial providers to register with the Securities and Exchange Commission,” said Chairman Kanjorski. “The past year has shown that the deregulation or in many cases, lack of regulation, of financial firms is an idea of the past. Advisors to financial firms must receive government oversight and we must understand the assets of financial firms, including for hedge funds, private equity firms, and other private pools of capital. Under this legislation, private investment funds would become subject to more scrutiny by the SEC and take more responsibility for their actions. I look forward to moving this legislation to the House floor for a vote.”

A summary of H.R. 3818 follows:

Everyone Registers. Sunlight is the best disinfectant. By mandating the registration of private advisers to private pools of capital regulators will better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole.

Better Regulatory Information. New recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries.

Level the Playing Field. The advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

I recently read an article by a hedge fund administration firm which discussed hedge fund offering documents and start up hedge fund expenses. I thought this was an interesting topic and one which is popular with many of my start up clients. Below I discuss some of the common questions regarding the offering documents and also provide reasons why a start up manager should use my law firm for starting a hedge fund.

****

Offering documents are just boilerplate – why are they so expensive?

This is a common misperception. Offering documents (if done correctly) are not merely boilerplate where the attorney pops in the fund name and the address – offering documents are a tailored to the specific needs of the client based on the client’s investment program and fund structure.

For instance, there are at least 12 different questions related to the management fee and performance fee/ performance allocation. There are at least 22 different questions related to the fund’s contribution periods and withdrawal periods. This level of customization does not come from a boilerplate form. Furthermore, many of these questions or options may have specific implications for the manager’s business either from a legal standpoint or a business standpoint. Many times the lawyer will need to have an in-depth discussion with the manager to help the manager determine which option is right for the fund.

Why are offering documents so long?

Offering documents are long – there is no getting around it. The structure of the offering documents are determined by the federal and state securities laws and thus there is not really any wiggle room. While it is often said that the hedge fund industry is “not regulated” or “lightly regulated” there are many hedge fund laws and regulations which managers must follow. These laws dictate many aspects of the documents and are why offering documents are so long (and also why offering documents from different firms are structured so similarly).

In this prior post, discussing “Prospectus Creep” we discussed the length of offering documents:

4. Is the Prospectus written for the Manager or the Investor?

Castle Hall discusses the interesting phenomenon of “Prospectus Creep” or basically the lengthening of hedge fund offering documents as hedge fund lawyers add more clauses to the documents which are designed to protect the managers. Castle Hall notes that “today’s offering documents are typically drafted to give maximum freedom of action for the manager and often permit unrestricted investment activities. Investors are also faced with offering documents which list every possible risk factor in an attempt to absolve the manager from responsibility under virtually all loss scenarios.”

HFLB: We agree that offering documents can be long and that often they contain a long list of risk factors associated with the investment program. The purpose of the offering documents is to explain the manager’s investment program and if the manager truly has a “kitchen sink” investment program, then all of the disclosures and risk factors are a necessary part of the offering documents. However we also feel that hedge fund offering documents should accurately describe the manager’s proposed investment program and that if the manager has a very specific strategy, he should provide as much detail to the investors as possible.

Can I draft offering documents myself? I have a friend who has some documents I think I can modify.

No. You should never draft offering documents yourself. I have seen countless examples of people who have tried to draft their own offering documents based on another fund. Many times these people will ask me to “check the documents.” Ninety-five percent of the time a brief skim of the documents will reveal major errors that cannot simply be fixed with a 2 hour review. In most all occasions the documents will need to be completely scrapped.

Are all law firm offering documents the same?

No, but law firm documents are all very similar.

It is an interesting phenomenon in the hedge fund legal world that attorneys are always interested in (or obsessed with) reading the other law firms offering documents. As one of those lawyers that is very interested in the differences between the offering documents, I have studied the documents from most all of the major hedge fund law firms including the firms listed below which are considered to be the best in the industry.

Sidley Austin

Shartsis Friese

Seward & Kissel

Kleinberg, Kaplan, Wolff & Cohen

Katten Muchin Rosenman

Schulte Roth & Zabel

Akin Gump Strauss Hauer & Feld

K&L Gates

I have probably read through 500 different offering documents (many from the same large law firms) and have found most documents to be quite similar. For the most part with a name brand firm you are going to get a quality product that is probably pretty equal to another large or name brand law firm. These documents will very likely protect you in all of the necessary ways.

However, that is not to say that all large law firm offering documents are perfect. I have seen offering documents which cost over $70,000 with typos and errors. Many times expensive offering documents are sloppy in certain respects – I expect this is because many large law firms use inexperienced associate attorneys to draft the offering documents.

Does price equal quality?

Not necessarily. While you are less likely to receive white glove service from a document shop, BigLaw does not necessarily equate to fine quality – especially for small and start up managers. In a large law firm you are going to probably initially talk with a partner about your program who will then relay the information to an associate who will be in charge of your project. This means that your offering documents are likely drafted by an overworked associate who has relatively little experience.

I always recommend a start up manager ask the law firm who will be drafting the offering documents and how much experience the person has. Many large law firms will say that an associate will draft the documents but the partner will review prior to finalization. I find it hard to believe that a partner will review offering documents – many times this is not true.

Low cost offering documents – are you getting less quality?

In some cases yes, but in the case of my law firm documents the answer is a resounding NO. While my firm will charge around $13,000 to $18,000 for offering documents (considered to be on the lower end), this does not mean that the quality of my work is less than any other firm.

As I have mentioned before on this site, I have worked with a substantial number of start up hedge funds and have drafted the offering documents or worked on around 150 funds. Also, I have spent a great deal of time dissecting offering documents from a large number of firms. My dedication to completely understanding the offering documents, along with my passion for the industry and helping managers with their business issues makes my services a compelling alternative to other firms which may cost more.

Additionally, I value the client relationship and always strive to return emails and phone calls promptly.

Conclusion

While the offering documents are the tangible item which you receive from your hedge fund lawyer, it is not the only part of the representation. The offering documents are not valuable as objects, but really as a representation of the prior experience of the attorney who prepared those documents for your fund, based on your needs.

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about becoming registered as a CPO or CTA, please call Mr. Mallon directly at 415-296-8510.

It used to be, even just last year, that separately managed accounts were only offered in rare circumstances and only to a very select few investors. However, an increasing amount of managers are offering their hedge fund programs to investors through a separately managed account (SMA) platform. Market forces are pushing managers for more transparency and the managers are looking toward SMA programs more and more.

Background of the SMA

Basically a SMA structure is simply a managed account structure that many registered investment advisors used prior to the increased popularity of the hedge fund structure. In essence the manager has a power of attorney to trade the investor’s account. The investor retains many more rights in this structure and has more transparency into the underlying account, see hedge fund separately managed accounts.

As more and more frauds are discovered, transparency will become an even greater issue for investors. Due diligence should, likewise, increase.

Issues for the Manager

There are a couple of issues that the SMA platform presents to hedge fund managers. First, the manager will not be able to receive favorable tax treatment on its performance fee. One of the most desirable aspects of the hedge fund structure is that the manager can receive tax advantageous characterization on its performance fee (performance allocation) if the fund has underlying long term capital gains. With the SMA structure the performance fee will be taxed as ordinary income to the manager because there will be no “allocation” of the profits (because the SMA structure is not a partnership or taxed as a partnership).

The second issue that the manager should be aware of is that the SMA platform allows the investor insight into the manager’s proprietary trading program. Another central advantage of the hedge fund structure is that managers can keep their proprietary trading program secret. Investors in a fund generally will have no right to see the fund’s trades or inspect the fund’s assets. In a SMA the investor has complete transparency into the assets and the trades. While investors are seeking such increased transparency, the manager will need to weigh the marketing benefits of the platform against the potential downfalls.

Another issue is that the manager may potentially be subject to hedge fund registration if the amount of SMA clients exceeds either 5 (at the state level) or 15 (at the federal level). See also Issues with the SMA structure. A manager should discuss this issue with his hedge fund attorney.

Please contact us if you have a question or would like to start up a hedge fund.

In addition to hedge fund pitchbooks, managers will market their hedge funds through one page tearsheets. Hedge fund tearsheets are basically a snapshot of a hedge fund’s performance over time, as of a certain date. There are a growing number of companies out there which will produce tearsheets for managers, but many managers will be able to produce their own tearsheets internally. This article will discuss the common items found in most hedge fund tearsheets and will also provide an example of a tearsheet.
Overview of Tearsheets

Like the pitchbook, the tearsheet contains much of the manager’s contact information, as well as information on the terms of the fund and the fund’s performance. Below are some features which are common to most tearsheets:

Management Company Information – the management company will usually be named on the tearsheet. Usually the address as well the contact information for the firm will also be included.

Fund Information – the name of the fund is typically displayed near the top of the tearsheet. Other fund information usually includes: assets under management (AUM), leverage (not strictly necessary), fees (management and performance), and investment objective/strategy discussion.

Logo – many hedge fund management companies, and sometime the fund itself, will have a logo. In such event the logo is usually incorporated into the tearsheet.

Performance Results – there are a number of charts and graphs which show the fund’s investment returns over a certain period of time. A fund’s metrics are also discussed (alpha, beta, standard deviation, correlation, sharpe ratio, drawdown information, % of up/ down months, etc.). It is common for these returns to be compared to a comparable index and/or to the S&P 500. Performance results are usually shown in a graph figure. Monthly performance figures, growth charts, statistical analysis, risk-return scattergram, and other visual representations of the performance data may also be utilized.

Written Summary/ Discussion (optional) – sometimes managers will choose to provide a written discussion of the fund’s performance results for the period. This can be incorporated into the tearsheet or can be provided to investors as a separate document. Some managers choose to have more frequent tearsheets (e.g. monthly) and less frequently written discussions (e.g. quarterly or yearly).

Legal Disclaimer – a legal disclaimer should be included with all tearsheets. The tearsheets should also be reviewed by an attorney for legal compliance. While many tearsheets do not have the legal disclaimer, we do not recommend this practice as a tearsheet is a manager communication which will need to include the appropriate performance disclosures (see Hedge Fund Performance Reporting).

Optional – naming of the individual fund managers and providing biographical information such managers; including famous quotes, news articles, or quotes from news articles, etc.

Sample Hedge Fund Tearsheet

Our firm has prepared a sample hedge fund tearsheet (forthcoming). [HFLB note: please see the Fairfield Greenwich tearsheets which are great examples of hedge fund tearsheets – please note that these tearsheets have a very long legal disclaimer.]
Preparing Tearsheets

There are a number of firms which provide tearsheet preparation services. In addition to providing analysis, statistical calculations and graph preparation, these firms help to make the tearsheets aesthetically pleasing. Normally these arrangements are done on a flat fee basis.

Our firm can help you with the preparation of the tearsheets or can provide advice on the look and feel of a tearsheet which you have prepared. Please contact us if you have any questions on this or other hedge fund start up issues. Related articles include:

There are many reasons why managers will want to form hedge funds in offshore jurisdictions like the Cayman Islands or the British Virgin Islands. While a domestic hedge fund can be established in as little as two to three weeks (depending on whether the manager must be registered as an investment advisor), the offshore hedge fund will usually take around 6 to 10 weeks to form, depending on a number of different factors. This article will detail the process of creating an offshore hedge fund. Continue reading →

The following article on a green fund of hedge funds was originally published on the website www.socialfunds.com and can be found here. (For more information on environmentally focused hedge funds, please also see our article on Carbon hedge funds.)

SocialFunds.com — Kenmar recently announced that it will be launching a new SRI hedge fund of funds, the Kenmar Global ECO Fund SPC Limited, which will be available to investors July 1. Kenmar hopes to tap into the growing interest of investors in environmental, social, and corporate governance (ESG) issues while also achieving its goal of capital appreciation. Continue reading →

Many start-up hedge fund managers want to know if their friends and family can invest in the start-up hedge fund. Most of the time, such friends and family do not fall within the definition of accredited investor under the Regulation D rules. The regulation D rules allow a maximum of 35 non-accredited investors to invest in any single offering. Because a hedge fund offering is continuous, the limit of 35 non-accredited investors is cumulative. That means that over the life of the fund there can be no more than 35 non-accredited investors (as opposed to 35 non-accredited investors in the fund at any single point in time). Continue reading →

A common issue which often arises is exactly what manner in which the investors actually subscribe to the fund and how the fund actually invests the money. The attached chart (Hedge Fund Organizational Chart) provides a typical hedge fund organizational structure. The chart also details the movement of the management fee, the performance fee, the movements of money, and hedge fund subscriptions or withdrawals. Continue reading →